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Russia's Biggest Economic Problem by Far Has Nothing to Do With Western Sanctions

In the coming years and decades Russia is going to face an extremely difficult challenge for its economy -- shrinking labor pool

The collapse in life expectancy in the mid-1990s to around 56 years for Russian men is about to hit the national economy hard, as it will cause the number of working-age people in Russia to fall dramatically over the coming years.

The Kremlin has responded firmly by finally calling for retirement ages to be raised from the Soviet levels of 55 years for women and 60 years for men to 60 and 65 years, respectively. President Vladimir Putin already in June signed an order to start the six-year transition to the new ages for civil servants and the rest of the country is supposed to follow soon.

The change is part “Plan K”, the Kremlin's third attempt to reform Russia, led by former finance minister and current co-chairman of the presidential economic council Alexei Kudrin. The higher retirement ages will keep 4.5mn more workers in the labour pool and mitigate much of the lost headcount due to the demographic catastrophe of the 1990s.

Keeping factories full is going to mitigate some of the economic slowdown that a shrinking workforce would have caused, as the average age of the worker will increase substantially. But the hike in pension ages is no more than a stop-gap measure.

The cost of labour

Demographic trends are key to the labour supply and the relative price of labour determines the distribution of income between corporate profits and workers’ wages, and eventually the level of investment activity, say analysts at VTB Capital.

The centre piece of Plan K is to refashion Russia from a consumption model that drove the economy for much of the last decade, to a new model where investment becomes the key economic driver, modernising the economy in the process.

Over the last decade and half, wages have been rising by about 10% a year on average and the share of wages has risen from 40% of GDP in 2000 when Putin took over to 52% in 2014 when the latest crisis started, putting Russia’s economy on a par with the developed world. Over the same period, the share of wages in the economies of other leading emerging markets fell to 40% of GDP.

It has been Russia’s companies that have paid for this increase in wealth for the people (and Putin has also reaped the political benefit of being extraordinarily popular). But over time the profits at companies have been steadily squeezed, falling from 43% of GDP in 2000 to 32% in 2014. In December 2014 companies could no longer afford to pay, as their margins were squeezed to nothing and at that point real incomes began to fall for the first time on Putin’s watch.

Kudrin’s plan aims to tackle this problem and swing the pendulum back in the corporates’ favour by holding down wage increases. The hope is that by widening company margins again they will take some of the surplus cash and invest it, resulting in greater economic growth. For a typical industry 22% of total manufacturing costs are due to labour (including social security payments), estimates VTB, while the share of labour in the total added value of the economy is 45%.

An aging population will reduce the share of value added from labour, and unless this is replaced by improved productivity from investment, the economy will continue to stagnate.

From a working population of 85.7mn as of 2015, Rosstat’s baseline forecast shows the working age population declining 5.5% by 2020, or 4.7mn people, almost exactly the same amount as Kudrin’s new working would-have-been pensioners, and a further 10.4% and 16.5% (compared with 2015) by 2041 and 2051, respectively, VTB calculates.

Those later declines in working population are more than a pension age reform can cope with. In effect, the increase in retirement ages are a stop-gap measure to buy several years time – enough it must be hoped for the investment driver to kick in and start working. In the longer term, Putin laid heavy emphasis in his speech at the St Petersburg International Economic Forum (Spief) this year on raising productivity and training a more creative work force, as well as moving more workers into the private sector by stimulating the small and medium-sized enterprise (SME) sector.

Ironically, the reforms that the Kremlin has already made in health care are working against the government because life expectancy is trending higher, increasing the dependency ratio (DR) of pensioners on the number of workers needed to support them.

The DR ratio bottomed at 58.6% in 2006 (just under two workers to pay for one pensioner), but since then has risen to 72.4% in 2015. And it will only get worse as the forecast is for it to climb to 84.3%, 90.6% and eventually 104.8% by 2021, 2041 and 2051, respectively, when one worker will be supporting more than one pensioner.

The bottom line is that for the first time since Putin took over, government policy will make the key difference to where Russia goes from here.

Aged and in work

However, there are other mitigating factors that could come into play to ease the demographic pressure imposed by the falling size of the working population.

One is that pensioners don’t have to stop working once they reach the retirement age. Indeed, in the 1990s the most stable households were those that had a pensioner living there as their state pensions and benefits were a major contributor to the income of the household. Today, Russia has 14.9mn nominal pensioners who are still working and with lengthening life expectancies and generally improving public health, the participation rate should rise.

“According to Rosstat, the share of the economically active population in Russia has been steadily rising to 69.1% in 2015 from the low of 61.1% in 1998, above the OECD average of 60.1%,” VTB says. “This elevated level of economic activity ratio hints that the potential to increase the labor supply via higher participation might be limited.”

Another way of increasing productivity is to move workers from the countryside to the cities, from agriculture to industry. While this obviously remains a major growth driver in most of the other BRIC countries, Stalin’s industrialisation drive in the 1930s exhausted this form of growth long ago in Russia. However, less dramatic but also significant will be moving labour from the public sector to the private sector, and Russia has this kind of growth available in spades; about half the working population is estimated to be either directly working for a state-owned enterprise, or one that is dependent on the budget for its main income.

Putin’s call in St Petersburg for promoting SMEs represents one of the least painful ways of moving workers out of the public sector and into the private one. Currently, SMEs account for about 20% of GDP and the plan is to double this share by 2030. However, SME promotion has been on the agenda since Putin took office and little progress has ever been made and won’t be unless corruption is tackled in parallel.

So much still needs to be done. Even if the worker-related reforms are put in place, there is still no guarantee that companies will follow through and increase their investment. Investment currently accounts for about fifth of total output, which is low by emerging market standards. The high cost of capital, political uncertainty, sanctions, the volatility of the currency, the lack of strong institutions to protect owners rights and the small circle of “stoligarchs” (Putin’s friends who control the commanding heights of the economy and operate outside the law) all undermine confidence and hold back investment.

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